[NOTE: this post originally didn’t have a letters-of-fire quote, and then that one dropped in our laps. Thanks Paul 🙂 ]

It’s beginning to look like the Madoff Ponzi was something of an open secret. Perhaps (and this is pure speculation) the more sophisticated investors then saw their risk as purely political, with the strength of their investment depending on Madoff’s nearly unassailable person. This would be analogous to the strength of Fannie’s and Freddie’s common stock after the Democratic Party gains in the November 2006 mid-term elections. That party was perceived as a source of support for the big GSEs, so in spite of their obvious intrinsic problems, shareholder confidence was boosted by their political ally’s success.

The morality play aspect of the affair already seems to be burning off a bit ("Madoff" no longer invariably appears somewhere on Google News Business’ front page). We’d better remember that morality as such rarely enters into capitalistic calculus. The starkest fact about this event is its sheer size. We can presume the initial $50 billion damage estimate was probably low. Quite simply, we’re looking at a fraud that’s too big to fail.

If the lame-duck Bush and the President-elect Obama teams let nature take its course, the unwinding of the Madoff Ponzi will strike each’s community of core supporters (but especially Obama’s) with a financial force to compare with the 1755 Lisbon Earthquake. That’s obviously unthinkable. Considering that relief is readily achievable through the TARP (all it requires is a Guinness World Record scale demonstration of nose-holding, but we are speaking about politicians here) it’s hard to imagine a scenario where help, indeed full restitution, would not be forthcoming. The most likely playing out of this little farce will be reports that CIPC will work to give the victims some of their money back, with the entire making-whole resources being laundered through CIPC over an extended period of time. The investors will be quietly assured early in the game that "the fix is in," though, if only to inspire confidence.

The idea that Treasury will be monetizing $50+ billion in fradulent conveyance resulting from a simple Ponzi is going to take some getting used to. But when you think about it, they’ve already bailed out a half-dozen situations over the last year or so that would appear to differ only in the complexity of the deals and structures that ran out of cash when the RE bubble burst. Who’s to know if at their foundations these bailed-out cinders weren’t just as much exercises in paying off early investors with the late investors’ inputs?

Meanwhile the cenbanks sold a significant amount, $15.2 billion, of Agency Debt in the week. Although overshadowed by the other number, this move just breaks the Agencies Top 10 list at #10. Still, combined with the huge buy of treasuries, cenbanks’ net holdings of US obligations rose by a robust $11.184 billion.

When you put those two moves together, you’ll see that the graphs for Treasury versus Agency debt are continuing to diverge. Treasuries are still climbing a wall, while agencies are steadily retreating at a slightly faster rate than they were advancing a year ago. Journalists are starting to write of a "bubble" forming in treasuries, and the acceleration of the yellow line’s upward arc would certainly suggest that such a conclusion is supportable.

UPDATE: The NYT’s Floyd Norris has an analysis [5] of foreign investors (cenbanks & others) buying treasuries and selling agencies in October. He coverage intersects some of the issues here. In particular, he has an updated version of something similar the 12-month-trailing graph that Brad Setlzer’s colleagues worked out at the Council on Foreign Relations and which Doom mentioned on October 27. The Norris piece started off:

AS foreign investors pour cash into United States securities, particularly short-term Treasury bills, they are pulling it out of the higher-yielding bonds issued by the government supported-entities Fannie Mae and Freddie Mac.

The moves appear to indicate that even after the government bailout of the two agencies, there is some lingering doubt that the government would actually stand behind their debts if their situation grew much worse.

Once more the huge absolute difference between the agencies dump and the treasuries gorge is pushing twist’s ratio graphs strongly downwards.